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From CBS Marketwatch:
A Bear Stearns Cos. hedge fund that made leveraged bets in the subprime mortgage market is worth nearly nothing, according to two people briefed by the investment bank.
Investors have been waiting for Bear to update them on the High-Grade Structured Credit Enhanced Leveraged Fund and a larger, less leveraged fund called the High-Grade Structured Credit Fund.
The Wall Street Journal reported on Tuesday that the larger High-Grade Structured Credit Fund is worth roughly 9% of its value at the end of April.
For those of you catching up on this story, here's the short version. About 2-3 weeks ago, Bear Stearns announced that two hedge funds invested primarily in the structured finance area (Collateralized Debt Obligations and Collateralized Loan Obligations) were experiencing record redemption requests. The problem with these requests is the fund was heavily leveraged -- meaning they had borrowed a ton of money. Reports have the leverage ratio at either 9 or 10 to 1, meaning for every $1 in equity/investment there were at least $9 or $10 in borrowed funds. These redemptions forced the funds creditors to make a margin call, or asking for their money back. Eventually , Bear made a loan of $1.6 billion to the funds to bail them out. Now, a few weeks later, we learn the fund is pretty much worthless.
The fall out is starting to spread:
The ABX index, which tracks the performance of various classes of subprime-related bonds, hit new lows yesterday. In the past few months, the portions of the index that tracked especially risky mortgage bonds with junk-grade ratings had been falling. But now, the portions of the index that track safer mortgage bonds, with ratings of triple-A or double-A, are also falling sharply.
The portion of the index that tracks triple-A subprime debt issued last year has fallen about 5% in the past week. The portion of the index that tracks low-rated triple-B bonds is down more than 50% this year.
A few weeks ago, I debated Barry Ritholtz of the Big Picture Blog about the CDO/CLO market (see the article Two Views of the Structured Finance Market). I took the more optimistic view that the damage would be contained. My central argument was the problems with the Bear funds were simple stupidity. A fund that is leveraged at 9 or 10 to 1 is asking for trouble. Barry took the less optimistic view that the fallout would spread.
I still hold to my argument -- what we are really going to see are a few hedge funds that made incredibly stupid decisions. My guess is Bear loaded up on the more speculative parts of the market and got burned. This would be akin to investing in a ton of people who have incredibly poor credit histories, borrowing a ton of money to make the investment and then being surprised when the borrowers don't pay the money back.
There is the possibility of a wider fall-out. Barry asked 10 questions on his blog that deserve to be answered:
- What would have happened had Bear Stearns simply let their two funds, High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, dissolve?
- If CDOs are not priced to market, what are the actual values of these holdings?
3. How levered up are the funds that own the bulk of the CDOs? 10-to-1? 20-to-1? More?
- How many Hedge funds are or have been taking quarterly or annual performance profits, based in whole or in part, on holdings that have been marked to a theoretical value ("Mark-to-Model") versus an actual value ("Mark-to-Market")?
- Liquidity has been a driving force behind M&A activity, share buybacks, and leveraged buyouts. Might the CDO situation somehow impact liquidity?
- Might a liquidation in a CDO/illiquid derivative fund spread to other asset classes?
7. How widely held are the toxic CDO tranches in funds that are self-decribed as "conservative" or "risk averse?"
- How accurate are the major ratings firms (Moodys, Standard & Poors, Fitch) assessment of these products. Are these outfits arm's length objective raters, or are they merely corporate whores who play for pay?
- After the final chapter is written on CDOs, what might the total losses on the $250 Billion in quarterly CDOs that Wall Street has created actually be? 10 Billion? 100 Billion? 1 Trillion?
- How much will systemic confidence be impacted if there is a series of large fund failures due to CDOs? What impact might that have on the rest of the markets?
I highlighted Barry's 3rd and 7th questions because I think these are the keys going forward. The key questions to be answered are how many other funds look like the Bear Stearn's fund in terms of lack of diversity and/or massive amounts of leverage?
My experience with money managers is the majority are incredibly smart and responsible. While most may allocate a small portion of their portfolio to riskier investments, the amount invested in these areas is small enough that a complete loss would not harm the overall fund in a large way.
However, I am also expecting at least 4-5 other funds to have the same problems. And it's not that I know this for a fact, it's just that there are at least 4-5 other managers out there who are incredibly stupid and who would make a gamble like Bear did.
But, we'll have to wait.